Denis Ouellet's  Instablog

The equity light is green but look around before you seriously commit!

• S&P on pace for best January since 1997 Good news for bulls as stock market rally points to lift for 2013 (FT)

• S&P 500 Ends Above 1500 The S&P 500 closed above 1500 for the first time in five years amid better-than-expected earnings from P&G, Halliburton and others.

For eight consecutive trading days, the Standard & Poor's 500-stock index has edged higher-always by less than a percent-the longest string of gains since 2004. On Friday, it cleared a new milestone, closing above 1500 for the first time in five years.

• And it did so despite the sour performance of poor old Apple as its magical iPhones came up with the wrong numbers. (Barron's)
• Earnings exceeded projections at about 76 percent of the 147 companies in the S&P 500 that have released results so far in this reporting season, while 67 percent topped sales estimates, according to data compiled by Bloomberg.
• Of the 134 companies that have reported earnings to date for the fourth quarter, 69% have reported earnings above estimates. This percentage is equal to the average of 69% recorded over the past four quarters. The Information Technology (84%) and Materials (80%) sectors have the highest percentages of companies reporting actual earnings above estimates. In terms of revenues, 64% of companies have reported sales above estimates. This percentage is well above the average of 50% recorded over the past four quarters. (Factset)

Equities are rising right in the middle of the earnings season. This focuses the media on the single most important factor in equity valuation: earnings. S&P, the official benchmark, currently sees Q4 operating earnings at $25.18, up 6.1% Y/Y and + 4.9% Q/Q.

Supported by the ample liquidity supplied by central banks, low interest rates, stable inflation and generally encouraging economic data, better than expected earnings, even after their downward revisions of the past months, are driving equity prices higher. This is what happens generally when low valuations get support from rising investor sentiment backed by improving basic fundamentals. Earnings are nowhere from booming, but they are not collapsing as many feared, and the dreaded fiscal cliff is now regarded as a mere bump on the road.

The media have been much jollier recently as the U.S. and China have shown improving economic data while Europe seems to have stopped sinking. Money has started to flow into equities while investment "gurus" and other talking heads become more optimistic. For some strange reason, it has suddenly become in to be bullish. A return to all-time highs after a 125% rise in prices likely triggered this new fashion statement.

(click to enlarge)(Chart from Ian McAvity)

The fact is that quarterly earnings have peaked in Q2'11, right at the $24.06 peak of Q2'07, and have only been going sideways since:

Estimates now call for a break out to $26.25 in Q1'13, rising steadily to $29.72 in Q4. We shall see if that proves optimistic, as it usually does. Here's what Factset said Friday:

Corporations and analysts have begun lowering earnings expectations for Q1 2013. In terms of preannouncements, 28 companies have issued negative EPS guidance for Q1 2013, while just four companies have issued positive EPS guidance.

In mid-2011, when quarterly operating earnings peaked, the S&P 500 Index was in the 1300 range, 15% below its current level. However, U.S. inflation has dropped from 3.5% to 1.7%. Under the Rule of 20, such a decline in inflation warrants a P/E boost of 1.8, from 16.5x to 18.3x, an 11% valuation gain.

Trailing EPS could reach $98.85 when Q4 results are all in, a 2.5% increase over 12 months and only 1.5% ahead of their $97.40 level after Q3. Given inflation at 1.7%, fair P/E is 18.3x for a Rule of 20 fair index level of 1808, 20% above current levels!

When I turned the equity light to green on December 18, 2012, the S&P 500 Index was 25% undervalued based on the Rule of 20 with a technical downside to its 200 day moving average of 3.3%. The fiscal cliff was still looming but the risk/reward ratio was very favorable when many important economic and financial catalysts were improving.

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Currently, the upside to fair value is a still very appealing 20% but the technical downside has increased to 6.7% (200 day m.a. at 1400). The risk/reward ratio is still favorable but nevertheless somewhat less comfortable given the state of the economy and the political environment:

• The economy is likely to remain sluggish and volatile, preventing a sharp earnings acceleration, especially since margins are elevated. Earnings guidance needs close monitoring.
• The effects of the fiscal drags under way are unknown and they could be significant. The U.S. consumer is fragile and it remains to be seen if the so-called wealth effect stemming from rising equity and home prices can offset the harsh reality of a 2.7% hit on take-home pay.
• The housing market recovery has finally reached front page status. Yet, diminished disposable income and tough mortgage rules are significant hurdles to a sustained recovery.
• While housing (2.7% of GDP) gradually recovers, U.S. exports (14% of GDP) are slowing while signs of currency wars are increasing and widespread. Keep in mind that the U.S. dollar has depreciated nearly 33% against major currencies since 2002, 12% since 2007.
• What will happen with the upcoming $1.2B sequester soap opera?
• Effective corporate taxes are low and should be normalized somewhat until an eventual (?) tax reform is completed.
• The political landscape remains murky at best while the huge fiscal challenge remains. President Obama is clearly on the offensive with his obvious leftist bias.

In 2010 and 2011, U.S. equities rose within 5% and 8% of fair value respectively before retreating under the uncertainties stemming from the Eurozone crisis and the U.S. political mess (look at the McAvity sentiment chart above). The road to fair value is thus not straightforward and far from a slam dunk. Close monitoring of the risk/reward ratio and of high frequency data is paramount at this stage.

One big difference from the 2010 and 2011 episodes is that risk aversion has since essentially disappeared in the fixed income market while increasing on equities, almost the exact opposite as in 2000. This is unsustainable as this National Bank Financialchart shows:

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Fashion can lead people into unreasonable behavior. It was so fashionable to be bearish on equities in the late 2000s that most people totally missed the recent extraordinary bull market. Are we entering another period of euphoria where the U.S. becomes investors' darling? After all:

• The U.S. economy has become very competitive to the point where we may be into a "manufacturing renaissance".
• America is quickly becoming energy self-sufficient, boasting the world's lowest natural gas prices (by a mile) and exploding oil production. Another game changer!
• American companies have shown an uncanny ability to boost profit margins even in very difficult economic and financial conditions. Given the manufacturing renaissance and the energy game changer, corporate profits could continue to surprise on the upside.
• Institutional and individual investors are so underweighted in equities that we may be at the beginning of the "great rotation" which would create strong demand for equities for many years to come.

Perhaps, but for now, curb your enthusiasm somewhat and remain cool:

• Earnings have plateaued and are no longer rising. Let's see how they do in 2013. Keep using trailing earnings.
• Inflation has declined sharply to 1.7% Y/Y in spite of all the QEs, super QEs, LTROs and other central bankers' printing tricks. Lower energy costs have been very helpful but core inflation seems stuck at the 2.0% level while the median CPI has been climbing a steady 0.2% per month for the past 6 months.
• This means that equity values have little back wind to advance "naturally", unlike 2009-2012 when earnings were sharply rising and inflation declined. Until earnings rise again, equities need investor enthusiasm if undervaluation is to be narrowed, a pretty fickle ingredient if there is one.
• Politicians are very apt at moving sentiment and I suspect the next several months will provide them with ample opportunities to spur second thoughts in financial markets.

We must now become fashion watchers.

"Human beings desperately want to belong, but, they also desperately want to understand the environment around them. Often, the desire to belong and the desire to know the truth conflict. The idea of the majority view or the 'mainstream,' gives people the sense that they are a part of a group, and at the same time, gives them the illusion of being informed."
- Brandon Smith (via John Hussman)

The recent Barron's is a good example of crowd teasing:

The Next Boom Cheap natural gas and increasingly competitive labor costs are bringing factories - and jobs - back to the U.S. Eight ways to win.

It's Gonna Be Delicious Want a get-rich recipe? Start with our experts' mouthwatering investment bargains in energy, retailing, banking, and more. Up this week: Abby Joseph Cohen, Brian Rogers, Oscar Schafer, and Scott Black.

John Hussman had a good piece this weekend (Capitulation Everywhere), complaining about his lonesomeness in bear country:

(…) The bears are gone, extinct, vanished. Among the ones remaining, many are people whom even I would consider to be either permabears or nut-cases. (…)

And capitulation is everywhere. CNBC ran a story last week "Bears on the Brink: I Can't Fight It Anymore." Even the normally staid Alan Abelson of Barron's finally threw in the towel last week, abandoning his own caution that stocks have run too fast, too far, and suggesting that investors let their profits run "until they start to go the other way. After all, markets rarely fall out of a bed in one fell swoop as they did in 1987 and, more recently, the turn of the century, so there's usually plenty of time to cut and run … we hope." I suspect that Alan is actually gagged in a closet somewhere, and that someone is submitting rogue articles in his absence. Alan, I hope very much for your timely return. (…)

The equity light is green but look around before you commit! Over the shorter term, consider the following charts from Oakshire Financial before you blindly get fashionable. And keep good control of your portfolio beta.

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Extraordinary. We just witnessed the biggest net inflow into long only mutual funds since the height of the tech bubble in March 2000, and the fourth largest net inflow in history.

I am partly re-committing to equities after having been cautious since April 2012.

• The S&P 500 Index is 25% undervalued based on the Rule of 20.
• Earnings have peaked but are not collapsing like in 2007.
• Inflation has slowed and seems unlikely to re-accelerate soon.
• The U.S. economy remains ok. Avoiding the fiscal cliff removes a big short term threat. Christmas sales look ok.
• Oil prices are not a big threat although Middle East tensions remain.
• The Fed keeps pumping.
• China is not hard landing, actually showing signs of re-acceleration.
• Europe remains in poor shape but the ECB will act as a backstop if things get worse.
• Technically, U.S. equities look good with stocks above the rising 100-day and the 200-day moving averages. Technical downside is 1390 on the S&P 500, -3.3% from the current 1438 level.
• Not a slam dunk but, all in all, the risk/reward ratio is very favorable and many catalysts are turning positive.

Larger Rule of 20 chart here.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The way I approach equities is pretty simple and rational: I first look at the valuationfacts provided by the time-tested Rule of 20 valuation method. Are equities cheap or expensive on the basis of trailing earnings and inflation rates? Most of the time, this is enough, as equity markets have this tendency to cycle through cheap and expensive territory in a pretty regular fashion. Once valuation facts are established, I look at the overall environment to assess how investor sentiment is likely to evolve and whether I can see a trigger that will unlock the cyclical forces and move equities toward their next valuation level.

The black line in the chart below provides a good visual of the valuation cycles since 1956 but you can go back to 1927 if you prefer (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years). At a minimum, it should convince you of the need for a rational, patient, facts-based approach to equity investing (buy low, sell high!)

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Equities have a general tendency to move from undervaluation to overvaluation in a pretty straightforward fashion, very much like economic cycles and greed and fear patterns. However, there have been a few periods when investors' patience was truly tested like 2 years of cheap equities in 1959-60, many years of generally expensive equities in 1968-75, 4 years of very cheap equities in 1982-85 and 6 years of extraordinarily expensive equity markets between 1997 and 2002.

U.S. equities got extraordinarily cheap in early 2009, then doubled to fair value in early 2010, fell back to attractive levels in mid-2010, and almost reached fair value in the Spring 2011. They regained a cheap label in mid-2011 and have remained very cheap ever since.

Last April, I raised the yellow flag above 1400 on the S&P 500 Index arguing that the 18% undervaluation should be discounted:

I sense that it is unlikely that markets will reach "fair valuation" (1650) within this complicated context. A repeat of last spring is more likely: in April 2011, the S&P 500 came within 10% of the Rule of 20 fair value before correcting (18%!). If 90% of fair value is all we can hope for, that's 1485, less than 10% above the current level.

Given the "technical gap" which might get aggravated by disappointing earnings, 10% upside does not provide a good risk/reward ratio.

On June 6, I wrote BANKING (BETTING) ON BANKERS? with the S&P 500 at 1278 and concluded:

We could well be about to get a big equity rally. Fear is extreme and visibility is very low, explaining the very attractive valuation. Normally, this is the time to close your eyes, pinch your nose, take a deep breadth and buy stocks. (…)

Central bankers are watching the games of chickens, shouting advices in ways never heard before, warning the chicks that the Banks are running out of tricks to meet the swelling challenges. Should we bet on Bankers being heard, and listened too? (…)

Stocks are very attractive, but the environment is too toxic. This chicken is willing to leave money on the table until he feels safer. Better be safe than sorry.

We are now back to the Spring peaks of 1420 even though earnings have stalled, the world economic environment has significantly degraded and politicians are totally hopeless just about everywhere we look.

The truth is that cheap equity markets are always on the look for catalysts to unlock value.

Enters Super Mario with his uncanny ability to find, or at least speak his way out of the ECB regulations straightjacket. Since his famous late July words

"…the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.",

U.S equities have jumped nearly 7% in less than 3 weeks. Bernanke's QE2 announcement lifted markets 7.5% in 2011 but his was an official and definitive announcement. Draghi's words, up to now, remain only that, as they need the labyrinthine and often (always?) elusive translation-to-real-action from all kinds of political and regulatory bodies and committees with the E.U.

Interestingly, even though the S&P 500 Index is merely back to its early April peak, its valuation has improved from a 15% undervaluation to a 23% undervaluation. That is because trailing earnings have gained 2.4% since April and, importantly, U.S. inflation has declined from 2.7% to 1.4% as measured by the CPI. Under the Rule of 20, fair PE is 20 minus inflation so fair PE has increased from 17.3x to 18.6x, a 7.5% improvement.

Markets are presently hopeful that central bankers (ECB, Fed, BOE, BoJ and PBoC) will soon collectively and simultaneously manufacture and deliver all the financial heroin the world economies need to vaporize more than a decade of political, economic and financial stupidities into oblivion.

But the Rule of 20 is there to keep us rational and focused and it is shouting to buy equities. Look at the chart: 23% undervaluation (15.4 on the Rule of 20 scale) has very rarely happened in the last 80 years. What could go wrong?

• Earnings could start declining. After all, they seem to have stalled, being up only 2.5% YoY in Q2 and Q3 estimates lately being ratcheted down to a 0.8% YoY decline. Factsetreports that 76 companies have issued negative Q3 EPS guidance against only 20 positive.
• That said, my June 6 post detailed many periods when equity markets rose even though earnings were declining. However, in all 7 cases since 1938 where equities advanced against declining earnings, inflation declined along with EPS, further proof of the usefulness of the Rule of 20 which says that fair PE is 20 minus inflation. In effect, a 1.0 decline in the inflation rate offsets a 5% drop in trailing earnings.
• The problem this time is that inflation has already declined to pretty low levels, from 3.9% in September 2011 to its recent 1.4%. Further declines from here would bring us very close to deflation. The U.S. has experienced only 5 bouts of deflation since 1930, all but one (2009) having occurred between 1930 and 1955. Excluding the depression period of 1929-34, all other four periods of deflation began with deeply undervalued equity markets and ended up positively for equity investors, even though earnings declined meaningfully in 2 of the 4 instances (1938-39 and 2009). The other 2 periods, when earnings kept rising, were right after WWII and likely benefited strongly from reconstruction expenditures in Europe and Asia.
• The big differences this time are that the intertwined world economies are all weak and still weakening (extremely weak in Europe), sovereign debt levels are extremely high and budget deficits are out of control. Moreover, political leadership is but a fading ethereal concept. In effect, world economies are being artificially sustained by central bank financial heroin which the world needs in ever rising quantities only to keep emitting surreal breathing sounds.

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What to do? Given that the salmon fishing season is over for me, what else can I invoke to justify staying put in the face of hard evidence that the huge liquidity out there only needs a little push to pounce on cheap equities. Is Draghi enough of a pusher? Daddy, are we there yet?

Draghi's gambit is bold and smart but remains hypothetical to this day:

• ECB intervention is conditional on countries such as Spain and Italy making formal request for EFSF/ESM help. Not a given, especially in Italy.
• The ECB seniority status remains to be dealt with. Not a given.
• How much firepower? What about the fact that Italy (18%) and Spain (12%) are supposed to contribute 30% of the EFSF funding? Who will backstop them?

Also, keep in mind that whatever the ECB does, its financial patch will do little to turn the economic tide which, to this day, remains very worrisome in Europe but also in the U.S. and in China. Ask the Greeks, the Irish and the Portuguese how their austere rescue packages have improved their lives in recent years. Recent PMIs keep flashing to a weaker outlook. If slower inflation, or deflation, is not accompanied by better economic trends, sales and profit margins would suffer.

The only potential game changer I see over the short term is a meaningful and sustained decline in oil prices which is not happening in spite of declining demand and increased Saudis exports. The Iran/Israel risk keeps world prices high enough for the Saudis to meet their budget but also for just about everyone else on the planet to miss theirs.

U.S. equities are very cheap but the hope rests essentially on closing the gap to fair PE while the earnings tail wind has quieted to a virtual standstill. Given the dire state of the world and so little political leadership, I'd rather bet on rising earnings than on rising PE's.

The "R" word

Just about nobody is talking about the risk of a U.S. recession these days. Yet, the dependable LEI from the Conference Board is flirting with a recession signal as Doug Short's great charts illustrate.

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If bankers and politicians deliver, I might revisit but, for now, I remain cautious, and safe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.